§ Levered and Unlevered Betas
§ A firm’s unlevered or asset beta is the weighted average of its
equity and debt beta
§ The equity beta reflects the effect of capital structure on its
risk
UED
ED
ED ED
bbb
=+
++
( )
EU UD
D
E
bb bb
=+ -
§ The value of the firm is irrelevant of its capital structure choice
– i.e. how much debt or equity it chooses to issue
§ However, using debt changes the risk-return of levered equity
§ Levered equity is more risky than unlevered equity, and
requires a higher rate of return
§ MM I - In a perfect capital market, the total value of a firm’s
securities is equal to the market value of the total cash flows
generated by its assets and is not affected by its choice of capital
structure
§ MM II – The cost of capital of levered equity increases with the firm’s
market value debt-equity ratio
§ Levered and Unlevered Beta
( )
EU UD
D
E
bb bb
=+ -
Chapter 15
Corporate Finance: The Core (4
th
Edition)
Berk/DeMarzo
§ Relaxation of the perfect market assumption
§ Interest tax deduction (tax shield)
§ Value of a levered firm
§ WACC with taxes
§ Effect of leveraged recapitalization on the value of equity
§ Personal taxes and corporate taxes
§ Optimal level of leverage
§ Under-leveraging
§ Tax is paid on profits after interest payment deductions –
therefore interest expenses reduce the amount of corporate
tax
§ Assume a tax rate of 35% for Macy’s
§ As shown, leverage reduces net income – but how about
the total amount available to all investors?
§ Leverage increases total payout by $140 million
